Variable Annuity Watch

I feel a twinge when I start to write this particular column because I'm pretty sure I won't have anything good to say. This year, as with many preceding years, variable annuities are a good deal for insurance companies but a lousy deal for investors.

This isn't personal. It's about the numbers. Just as managed mutual funds have to swim against the tide of their own expenses, variable annuities have to swim against an even faster tide of expenses.

The last year has not been an exception. Indeed, it was worse than most. No one wants to pay for tax deferral and then have no gains to defer.

The idea here is simple. Each year we measure the return of an inexpensive, tax-efficient index fund against every variable annuity sub-account in its category. Then we figure the probability that you would have done better with the simple index fund than with a variable annuity. Tax deferral didn't mean much in this exercise, but if you want to see how little it has meant for earlier periods, just visit my Web site.

Domestic Equities.

As of June 30 there were 6,689 variable annuity sub-accounts categorized as "large blend" by Morningstar with 10-year track records. The group had an average expense ratio of 1.97 percent a year and lost money at an annualized rate of 2.46 percent over the entire 10-year period. The Vanguard 500 Index fund cost a mere 18 basis points, or 0.18 percent. It lost slightly less than the average sub-account, 2.29 percent a year.

Ranked against all 6,689 sub-accounts, the index fund would have placed 2,505. So it beat 63 percent of all its surviving competitors.

The word surviving is important. According to a recent report, only 61 percent of all large blend managed mutual funds survived the last five years. It's a statistical leap, but it isn't unreasonable to guess that the index would have beaten more than 80 percent of its original competitors over the last 10 years.

International Equities.

The 2,071 surviving sub-accounts with 10-year records classified by Morningstar as "large cap blend international" had an average expense ratio of 2.10 percent and a 10-year return of 0.13 percent a year. Vanguard Total International Market fund had an expense ratio of 0.34 percent and an average annualized return of 2.18 percent. The index fund would have ranked 386, beating 81 percent of its surviving competitors.

Moderate Allocation Funds.

The 3,279 surviving moderate allocation sub-accounts had an average expense ratio of 2.07 percent and a 10-year annualized return of 0.44 percent. The Vanguard Balanced Index fund has an expense ratio of 0.25 percent and a 10-year annualized return of 1.86 percent. It would have ranked 693 in the group, outperforming 79 percent of its competitors.

Intermediate General Bond Funds.

The 2,943 surviving bond funds with 10-year records had average expense ratios of 1.74 percent and returned 4 percent annualized over the last 10 years. The Vanguard Total Bond Market index fund has an expense ratio of 0.22 percent and provided an annualized return of 6.39 percent over the period. It would have ranked 55th in the group, beating 98 percent of its competitors.

Given the odds against superior performance, it's clear that simplicity and low cost are a better deal for investors than complexity and high cost.

The insurance industry has countered this statistical reality with an offer for "living benefits." Pay an extra fee that takes the annual expense of the product to about 3 percent a year, and they will guarantee that you can withdraw 5 percent a year from your original investment as long as you live, regardless of what the market does.

Sounds pretty good, right?

Well, think again. The purchase of a $100,000 variable annuity contract with such a guarantee means a 65-year-old man can have an income of $5,000 a year, or $417 a month for life, from his investment. He will get this regardless of what happens to the market. He might even get more if his account can rise over the burden of 3 percent in expenses and $5,000 annual withdrawals.

According to, the same 65-year-old man can buy a life annuity that will pay $417 a month for life for about $61,000. That means he'd have $39,000 "left over" to invest for more income later.

On the Web

Variable Annuity Watch, 2008:

Variable Annuity Watch, 2007:

Variable Annuity Watch, 2006:

Variable Annuity Watch, 2005:

Variable Annuity Watch, 2004: